The deal, which would create a firm controlling nearly one third of the domestic market, would see Showa Shell's largest shareholder, Anglo-Dutch oil major Royal Dutch Shell, selling shares in a tender offer, the Nikkei business daily said without naming its sources.

Royal Dutch Shell will likely exit the oil-refining and sales business in Japan, due to thin margins caused by fierce competition, it said.

Idemitsu, which plans to turn Showa Shell into a subsidiary, would become number two in Japan's oil distribution sector, behind JX Nippon Oil & Energy, the Nikkei said.

Idemitsu and Showa Shell are expected to sign a basic agreement as early as February, with the tender offer to be launched pending regulatory approval, it said.